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macronotes_cycles

# macronotes_cycles - PART III OF THE COURSE AGGREGATE DEMAND...

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PART III OF THE COURSE: AGGREGATE DEMAND AND BUSINESS CYCLES I Sources of Aggregate Demand (chapter 11) Definition 62 AGGREGATE DEMAND (AD): is the relationship between real GDP de- manded and inflation Aggregate demand is much different than micro demand. No substitution effects. All goods are in the GDP. When the price of tomatoes goes up and we buy carrots, the GDP is unchanged and aggregate demand does not fall. We are talking about real variables. Why should changes in a price index affect real things? Sources of AD: Y = C + I + G + X - M (70) AD is the sum of consumption demand, investment spending demand, government spending demand, and net export demand. Aggregate demand looks at GDP from the spending side (expenditure approach). Let us look at each component of demand individually. We will see that several components of expenditures are affected by interest rates. In turn, interest rates are affected by inflation which will lead to the downward sloping AD curve. Hence the ‘substitution’ will be between consuming and saving rather than consuming one good or another. A Consumption Demand Definition 63 CONSUMPTION: Purchase of finished goods and services by households. 1 Income and Consumption Demand Even those with no income consume something. Let that amount of consumption be denoted by a . Then suppose that we consume b units for each dollar of income. We then have the consumption function: C = a + bY (71) 56

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Definition 64 The marginal propensity to consume (MPC) is the fraction of income spent on consumption. The MPC may also be calculated via the slope formula: b = Δ C Δ Y (72) The MPC as shown above is about 0.6. 2 Taxes and Consumption Demand In reality consumption depends on DISPOSABLE INCOME ( Y D ): Income after all taxes and transfers. Y D = Y - T + TR (73) The standard consumption function proposed by Keynes in 1936: C = a + bY D (74) The after tax mpc is typically around .95. So of the 40 cents not consumed, about 37 cents goes to taxes and only about 3 cents is saved. See graph. 3 Interest Rates and Consumption The income not used for consumption is saved. As interest rates rise, consumers save more and consume less. R C Figure 19: Consumption as a function of interest rates. 57
4 The Spending Balance An increase in C causes and increase in income for someone via: Y = C + I + G + X - M (75) We also know that an increase in Y generates an increase in C via the consumption function: C = a + bY D (76) So an increase in C results in an increase in Y which results in an increase in C ..... Where does it end? Examples: 1. Tax cut. One might be tempted to think a \$100 tax cut generates \$95 in extra C and therefore \$95 in income, which is the benefit to the GDP. But instead we must trace out the entire effect: that \$95 in income increases someone else’s consumption, which generates more income and so on.

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macronotes_cycles - PART III OF THE COURSE AGGREGATE DEMAND...

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